Aging, the World Economy and the Coming Generational Storm

Studies | Economy

No. 273
Friday, February 04, 2005
by Laurence Kotlikoff, Hans Fehr, and Sabine Jokisch


Simulations for Closed Economies

“The closed economy simulation assumes no capital flows.”

Our first set of simulations treats the three countries — the United States, Germany and Japan — as closed economies. This means that we assume no trade and no capital flows and that each region is a self-contained economic unit. This type of simulation is especially useful as a point of comparison for the international effects of aging in the open economies model (discussed below).

Table I - III

Baseline Simulations. Tables I, II and III give selected results for each of the three regions, with Social Security payroll tax rates and the income tax rate on labor reported in the right two columns. As Table I shows: 

  • In order to finance elderly benefits in the United States, the payroll tax must climb from 14 percent (the current pure pay-as-you-go rate) to 23 percent over the next 30 years, while the average income tax will rise from 10 percent to 14 percent.
  • The total tax on wages will rise from 24 percent to 38 percent by 2030 and to 40 percent by mid-century.

“Higher taxes and less saving will create a capital shortage.”

Higher taxes mean lower after-tax income for workers. But they also have another, highly damaging effect. Less disposable income means less saving; less saving means less capital formation; less capital formation means lower labor productivity; and lower labor productivity means lower real wages.

Specifically:

  • Because of lower capital stock, the real wages of U.S. workers will be 11 percent lower than they otherwise would have been by 2030 and 15 percent lower by the middle of this century.
  • Combining reduced before-tax wages with expected higher tax rates implies that future workers must settle for a 25 percent cut in their standard of living by 2030.
  • By mid-century, the growth of elderly entitlements will create an American standard of living one-third lower than it otherwise would have been.

“Living standards will fall.”

Bad as these results are, the simulation for Europe is much worse — because fertility rates are lower and population aging is more severe. As Table II shows:

  • In Europe, where the total tax on wages is already above 40 percent, the total tax burden will rise to almost 60 percent by 2030 and approach a staggering 70 percent by mid-century.
  • Combining these tax rates with an 8 percent fall in real wages from relative capital contraction implies a 25 percent reduction in the average European workers’ standard of living over the next 30 years.
  • By mid-century, the relative fall in standard of living for European personnel will be close to 40 percent.

“By 2050, United States real wages will be 15% lower than otherwise and taxes on labor will approach 40%.”

The Japanese workforce already bears a tax on wages in excess of 40 percent, and its aging society will cause the payroll tax to double over the next 50 years. The overall results are similar to those for Europe. As Table III shows:

  • By 2030, the total tax on labor in Japan will approach 60 percent and Japanese workers will face a one-fourth reduction in their living standard.
  • By the middle of this century, the effects of elderly entitlements will push the Japanese tax on labor to 70 percent and living standards for Japanese workers will be 40 percent lower than they otherwise would have been.

“In the EU, taxes will claim two-thirds of wages.”

As one would expect from the population dynamics described above, the largest increase in payroll tax rates in the medium term occurs in Japan, where they double from 24.7 percent to 48.1 percent in the next 50 years. While European payroll tax rates are currently higher than Japan’s, their future increase is somewhat less pronounced, and they peak at 45.5 percent. Because the aging rate is less severe in the United States, Social Security taxes will rise less —from 13.7 percent in 2000 to 23.4 percent in 2030 and to 25.8 percent by the end of the century.

“In Japan, the total tax on labor will approach 70%.”

The picture is very similar in the case of income taxes. Due to generous public expenditures per capita in Europe, average income taxes on wages must increase steadily over the whole transition in order to balance the budget. While the current average rate is 13.7 percent, it almost doubles by 2100, reaching 26.8 percent. In Japan the average wage tax rate rises from 14.2 percent to 23.6 percent. In the United States, where public expenditures per capita are generally lower, the average wage income tax rate equals 10.1 percent in 2000, peaks at 16.0 percent in 2075 and falls to 15.5 percent by century’s end.

“In the open economy simulation, Europe and Japan bid capital away from the United States.”

To summarize, our closed economy, baseline policy simulations reveal a severe deterioration in macroeconomic and fiscal conditions in all three regions.


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